How Much Should You Reveal to the IRS?

Textron has spent three years fighting the IRS over access to tax accrual work papers that would, among other things, tell the agency exactly how confident the company was in its ability to prevail in any tax challenges.

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In the latest round of the three-year standoff between Textron and the taxman, the manufacturing conglomerate is on the ropes. Federal appeals judges recently found in favor of the Internal Revenue Service, which has been seeking Textron’s tax accrual papers under the assumption that the documents could lead to more information about whether the company had improperly reported its taxable income.

In the meantime, other corporations could also be on the losing side in any quest to shield the thought process behind their tax strategies from the prying eyes of legal adversaries, say attorneys. In fact, the dissenting judges in the case believe that because of the latest ruling, the existing law for protecting documents prepared in anticipation of litigation has been thrown “into disarray” and that the majority opinion could have “wide ramifications.”

Among the fears: state tax authorities could believe they have more wiggle room to demand work papers from corporate taxpayers. And, worried the internal documents could be subject to public scrutiny, companies and their attorneys may be less detailed in what they decide to record, which could lead to less accurate information about tax reserves, and “could ultimately, indirectly have a negative effect on the quality of financial statements,” Michael Jacobs, a partner at law firm Reed Smith, told CFO.com. Reed Smith is not involved in the Textron case.

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The issue has divided the courts and judges. The U.S. Court of Appeals for the First Circuit was split 3 to 2 in its decision last week that Textron should turn over its tax accrual papers to the IRS. Tax accrual work papers contain legal opinions about tax positions and, for accounting purposes, data used to come up with how much money a company sets aside in case the IRS challenges its tax reports. They are generally viewed only by the companies, their attorneys, and auditors.

The IRS’s policy is to ask for these documents only when a company appears to have engaged in certain types of transactions that the agency has deemed related to tax-avoidance schemes. In 2006, the IRS asked for all of Textron’s work papers for 2001, as well as the work papers of Textron auditor Ernst & Young that were used in reviewing the accuracy of the company’s tax reserves for that year. The agency was concerned with nine sale-in, lease-out transactions used by a Textron subsidiary. Textron refused to share the data.

A lower court found in favor of Textron, and the IRS appealed. None of the court decisions have weighed in on whether Textron has done anything improper with regard to its income taxes.

The documents in question include a spreadsheet itemizing issues that could result in disputes with the IRS, percentage estimates of how likely it would be that Textron would prevail in those disagreements, and the amount of money the company set aside in case it lost its argument with the government.

At issue is whether Textron’s work papers are protected by the work-product doctrine, which keeps material prepared in anticipation of litigation from discovery during a court case. “Basically, we have an adversarial system to resolve disputes, and the work-product doctrine is important for preserving fairness in that process so that both sides have the freedom to prepare their case in confidence,” explains Kevin Kenworthy of law firm Miller & Chevalier, who is not involved in the Textron case.

In the majority opinion, Judge Michael Boudin wrote that because the documents were used for Textron in calculating its tax reserves for the purposes of financial reporting — and not specifically because of possible litigation — the papers are not protected.

Moreover, Boudin sympathized with the IRS and the “practical problems” of the agency’s ability to uncover underreported corporate taxes. “Textron apparently thinks it is ‘unfair’ for the government to have access to its spreadsheets, but tax collection is not a game,” he wrote.

Unless the information is privileged, the government should have access to “a blueprint to Textron’s possible improper deductions,” added Boudin.

Attorneys at law firm Reed Smith warn that Boudin’s decision could prompt state tax authorities to become more aggressive in getting companies to turn over work papers, which some have wanted to do since the passage of the accounting rule FIN 48 three years ago. The rule requires companies to disclose how much they have kept in reserve to cover the possibility that the IRS or state tax officials might disallow certain tax treatments.

In an alert to their clients, the Reed Smith partners suggest taxpayers label their work papers as being prepared under the prospect of litigation so that they don’t inadvertently give in to a demand for revealing privileged information. In addition, the attorneys suggest keeping work papers touching upon “hot button issues,” which could invite litigation down the road, separate from documents “related to less sensitive tax exposures.” They believe this could help limit disputes over confidential data.

Companies that can show their work papers would be useful for litigation or that they weren’t prepared solely for financial-reporting purposes may be able to deter the IRS’s summons, adds Kenworthy.

As for Textron, the company has not decided whether to appeal to the Supreme Court. A spokeswoman told CFO.com: “At this time we have received and are studying the decision, and are exploring our options.”